Consistent cash flow drives constant and growing payouts at both firms, but valuations are getting high, and smaller firms such as RPS Group (LSE: RPS) look even more attractive candidates for a short- to medium-term investment.
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The risk of over-paying
I’m a big fan of investing in larger firms with ‘defensive’ qualities over the long haul. Over a macro-economic cycle, Unilever’s consumer brand driven cash flow fluctuates far less than the cash-generating ability of firms in many other sectors. A similar story plays out with the cash earned by British American Tobacco’s smoking products, which enjoy the added ‘attraction’ of being addictive.
However, the valuations of these dividend-paying stars can wax and wane. If we pay too much to own a small slice of these enterprises there’s risk that our total returns could disappoint in the short to medium term if valuations happen to contract.
Unilever and British American Tobacco both expect single-digit earnings growth for 2016, which makes forward earnings multiples of 20 and 16 respectively look a bit rich. Those forward earnings will cover the firms’ dividend payouts around one-and-a-half times each, but the yields don’t seem to justify the ratings either — Unilever’s forward payment yields 3.2% and British American Tobacco’s 4.5%.
Meanwhile, FTSE Small Cap company RPS Group looks much better value. At today’s share price of 221p, the development, environmental and energy resources consultancy trades on a forward price-to-earnings multiple around 9.5 for 2016. The dividend yield runs at 5%, and the firm expects forward earnings to cover the payout just over twice.
The shares are down around 37% from the peak they achieved at the beginning of 2014. My guess is that the share-price fall last year tried to anticipate a much larger collapse in earnings than the 3% dip we saw during 2015. Now, with City analysts predicting a 9% uplift in earnings for 2016, RPS Group looks attractively priced.
The company’s business has a greater element of cyclicality than we find at Unilever and British American Tobacco, which accounts for the larger share price swings as investor sentiment changes. However, the down movement looks like it could be an ‘overshoot’ to me, which is why I think on a short- to medium-term view RPS could deliver investors a decent capital gain as well as a top-of-the-league dividend payment — after all, we’ve seen where the shares are capable of travelling.